How an operational CFO can better manage due diligence
Navigating the complex landscape of corporate transactions can be a formidable task, especially when it comes to due diligence. Traditionally the domain of investment bankers and corporate lawyers, due diligence is increasingly seen as a critical domain for an operational CFO. Serving as the link between financial insight and strategic execution, the full-time or fractional CFO's role in due diligence is crucial in guaranteeing the success of any corporate transaction.
This guide gives detailed insights into how an operational CFO can efficiently manage due diligence, focusing on important areas such as financial analysis, legal factors, and customer contracts. Whether you're part of a board of directors, an investment team, or are a full-time or fractional CFO, understanding these components can prove vital in making informed, strategic decisions.
Unpacking the due diligence process
Due diligence management can vary considerably based on the type of the corporate transaction. For a buy-side acquisition, a comprehensive, thorough approach is essential to uncover potential risks and opportunities. On the sell-side, although the process may be less demanding, thorough due diligence remains essential to maximize transactional value.
Every corporate transaction is unique, and as an operational CFO, making sure the due diligence process agrees with corporate strategy is vital. This starts by recognizing the underlying purpose of the transaction – whether it's expansion, consolidation, or diversification.
Determining this clarity will allow the CFO and other stakeholders to tailor the due diligence process to focus on areas that directly affect transaction success.
Financial insights and analysis
The mainstay of any due diligence process lies in detailed financial analysis. Normally, this entails examining three years of financial statements, ideally audited by an external audit firm. Forensic financial analysis should encompass a detailed cash flow analysis, a five-year financial forecast, and a financial ratio analysis. This deep-dive into the financials delivers an insight into the target company's operational health and future viability as a going concern.
Furthermore, an analysis of accounts receivable and payable aging lists can provide insights into the company's working capital management and liquidity position. This is particularly crucial for pinpointing any potential cash flow issues that might impact the corporate transaction.
With these insights in hand, the operational CFO is better equipped to deliver a convincing case to the executive board, potential investors and stakeholders about the merits of the corporate transaction.
Understanding legal complexities
Legal due diligence is necessary to identify any current or possible legal issues that could impact the target company's value or operational viability as a going concern. The full-time or fractional CFO must examine any existing lawsuits or outstanding government remittances, such as GST/sales or corporate income tax liabilities. These potential liabilities must be clearly reflected and noted in the company's financial statements to avoid unanticipated complications post-acquisition.
It's a common omission for companies to neglect fully provisioning for legal exposures, which can give rise to substantial financial headaches in the future. Establishing transparency in these issues can safeguard against unexpected liabilities and protect the company's interests.
Assessing customer contracts and retention
Customer contracts represent an essential element of the due diligence process. The certainty of sales income derived from these agreements can materially affect the stability of future cash flows. Understanding customer sales patterns, and recognizing whether sales are recurring or one-off, is important to assessing revenue reliability.
The operational CFO for due diligence purposes may decide to normalize revenues by excluding any one-off sales in the company’s forecast.
The full-time or fractional CFO must consider the industry setting of these contracts, as customers in more stable industries like government or healthcare are generally more reliable and predictable. Such customers can deliver a steady revenue stream as opposed to more volatile sectors like startups or consumer discretionary companies, which may pose additional risks such as not paying a sales invoice on time or purchasing less.
Unveiling the debt structure
A complete review of the target company's debt structure is crucial to fully comprehend its overall financial health as a going concern. This entails a detailed assessment of all forms of debt, including overdrafts, credit cards, lines of credit, and term debt. The operational CFO must also account for any hybrid securities such as convertible debt. Going deeper, it's imperative to differentiate between standard lending arrangements and those with higher interest rates that could indicate financial distress.
It's normal for companies to omit lease obligations when calculating debt servicing capacity. An operational CFO must ensure all types of financial obligations, including non-bank debt, are accounted for to give a precise snapshot of the target company's financial commitments during due diligence.
Scrutinizing contracts for compliance
Contracts are legally binding agreements, and any omission can have significant ramifications - and not just for the success of the potential corporate transaction. Scrutinizing all employment, consulting, and commercial contracts is critical to ensure compliance and mitigate risks.
Often, contracts are signed without proper authority, exposing the company to punitive consequences. The advent of remote working and electronic contract has resulted in an increase in documents never being properly executed too.
By guaranteeing all contracts are reviewed with legal counsel or governance oversight, an operational CFO can safeguard the company against future legal problems. This proactive approach also assists in recognizing any liabilities that could impact the transaction's success.
Assessing capital and fixed assets
A vital element in due diligence is assessing the state of the company’s physical or tangible assets. The condition of property, plant, and equipment can significantly impact future capital expenditure requirements and operational competitiveness. Identifying possible refurbishment or replacement costs is critical to planning future capital investments. This is pertinent for the operational CFO and stakeholders when forecasting investing cashflow needs for the target company during due diligence.
By examining these tangible assets' current state and maintenance requirements, a full-time or fractional CFO can develop a clearer picture of the company's long-term capital needs. This foresight supports better informed decision-making on whether these assets align with the company's strategic vision.
Inventory management and turnover
Effective inventory management is crucial to evaluating the company's operational efficiency. Large quantities of unsold inventory can signal deeper issues such as outdated stock, implying possible write-downs that will impact financial health. This sometimes causes tension between chief executive officers focused on growth and chief financial officers intent on financial discipline.
The operational CFO must ensure inventory is accurately and truthfully reflected on the balance sheet. Particularly for non-audited private companies, it's paramount to normalize and impair inventory where necessary to deliver a more accurate opinion of inventory value and potential financial trendlines to stakeholders.
The normalization of inventory under the parameters of US GAAP or IFRS is particularly true for private companies going public or being acquired by a publicly-listed corporation - where externally audited financial statements are mandatory.
Deciphering business units and subsidiaries
Appraising the performance of individual business units or subsidiaries is important for understanding the overall financial landscape of a target company. Consolidated reports can conceal underperforming entities that may demand closer analysis by the operational CFO and stakeholders. Isolating poor gross margins or inefficient headcount within subsidiaries can uncover opportunities for improvements or divestments.
Examining closely these details assists in revealing hidden liabilities, and confirms a more accurate appraisal of the target company. This deep analysis enables the operational CFO to isolate potential synergies or areas that demand immediate strategic intervention.
Key elements to guide success
The key to a successful due diligence process rests with thorough and comprehensive evaluation. The operational CFO must be prepared to rapidly analyze projected cash flows to expedite interest in a corporate transaction. If a target company's cash flows align with strategic objectives, the due diligence process's depth and efficiency can result in a smoother transaction.
Knowing these core elements will empower the full-time or fractional CFO to drive value and provide strategic insight. Equipped with these insights, a chief financial officer can provide recommendations with confidence, ensuring that due diligence becomes a strategic advantage, rather than a bureaucratic milstone.
Elevating due diligence to strategic insight
Overseeing a due diligence process demands strong attention to detail and a strategic mindset. For the operational CFO, building a robust due diligence framework is critical to unlocking corporate transaction value. This guide has reviewed essential areas including financial evaluation, legal scrutiny, and customer analysis, equipping the chief financial officer with the insights they need to succeed with a due diligence.
By tackling due diligence with a structured, strategic mindset, the operational CFO can transform what can often be a mundane, low value and box-ticking task into a powerful tool for creating value. Furthermore, understanding the importance of due diligence in corporate transactions emphasizes the important role an operational CFO can play in the success of businesses.